By Art Adams
Recent headlines in the media have cast a spotlight on previously little-known entities that are playing a key role in the credit market crisis that has been spreading throughout the financial markets. These entities are known as structured investment vehicles.
First created in 1988 by Citigroup, structured investment vehicles (SIVs) are investment companies engaged in a type of "carry trade." They borrow money using short-term asset-backed commercial paper issued at a rate closely approximating LIBOR interest rates. This asset-backed commercial paper typically is carried anywhere from a few days to a few months before needing to be refunded. SIVs then turn around and use the proceeds to purchase longer-term, illiquid, higher yielding bonds. About 70-80% of the bonds typically bought by a SIV are AAA/Aaa rated Mortgage-Backed Securities (MBS) and Asset-Backed Securities (ABS). The remainder are usually lower-rated, higher yielding assets such as sub-prime mortgages blended in to boost overall performance.
Thus, SIVs can be thought of as funding sources for mortgages, credit cards, student loans, and similar credit products. SIVs do not need to be displayed on a bank’s balance sheet and are not transparent to the majority of the investment community. Since SIVs are kept "off the books," they can operate with little regulation and can become highly leveraged. Sponsoring banks use them as a loophole to use more leverage than they otherwise would legally be allowed to. Citicorp once noted that the leverage in one of their particular SIVs, Beta Finance, is "only leveraged 14.24 times." When investments perform well, leverage is wonderful as earnings are greatly multiplied, when they go sour; leverage is a back-breaker as losses are equally multiplied.
SIVs seek to earn more on the longer-term securities they purchase than they have to pay out in interest and principal on the short-term commercial paper they issue. In other words, the goal of the SIV is to earn a net spread between the yield on its asset portfolio and its funding costs while also generating fee income for the investment manager.
Currently there are approximately 36 SIVs in existence, with total assets of about 400 billion dollars. Most SIVs are run or sponsored by banks, however several are managed independently. Below is a list of SIVs sponsored and run by major banks:
- AIG manages Nightingale Finance
- Bank of Montreal manages Parkland Finance and Links Finance
- Citigroup manage a number of SIVs including Beta Finance, Centauri Corporation, Dorada Finance, Five Finance Corporation, Sedna Finance, Vetra Finance and Zela Finance
- Citigroup and Rabobank jointly manage Tango Finance
- Dresdner Kleinwort manages K2 Corporation
- HSBC manages Asscher Finance and Cullinan Finance
- HSH Nordbank manages Carrera Capital Finance
- IKB managed Rhinebridge
- MBIA manages Hudson-Thames Capital
- Societe Generale manages Premier Asset Collateralized Entity (PACE)
- Standard Chartered Bank manages Whistlejacket Capital and White Pine Corp
- WestLB manages Harrier Finance
SIVs can earn good profits for sponsoring banks when the credit markets are properly functioning, but they are exposed to a liquidity squeeze if the asset backed commercial paper market shuts down. This is what took place beginning this past summer. SIVs have struggled in recent months with selling debt because a portion of their assets are backed by faulty US sub-prime mortgages that no one wants to buy.
Normally, risk-averse investors such as money-market funds, municipalities, and pension funds buy SIV debt. However, when these institutional investors stop buying and the short-term commercial paper debt comes due, serious liquidity problems develop. When this happens, prices of long-term debt investments fall and when SIVs suddenly experience an inability to sell their long term assets, major losses and write-downs can result.
At the present time there is an estimated $400 billion in SIVs outstanding with HSBC SIV affiliates chalking up $35 billion in debt while Citigroup affiliated SIVs try to cope with write-downs on $80 billion in assets.
Sponsoring banks have already announced over $60 billion worth of losses as many of the mortgage bonds backed by sub-prime mortgages have declined in value. These losses may be the tip of the iceberg as many banks have concealed their holdings of sub-prime mortgages within the SIVs they have sponsored. Although the banks say they do not own these SIVs, and are therefore not technically liable for their losses, they may be forced to cover any losses that may take place. If a further melt-down takes place within SIVs, we could see the liquidity crisis persist within the credit markets and this could have a negative effect on mortgagor loan funding as well as other credit products.
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